Volatility remains extremely high, with markets continuing to digest US CPI surprise and UK political saga. USD strengthens sharply amidst rising risk aversion, higher US rates

Friday saw more significant volatility across asset classes as markets continued to digest the upside surprise to US CPI from the previous session and the rapidly evolving political situation in the UK.  Global rates continue to push higher, with market expectations for the peak in the Fed funds rate and the RBNZ OCR now within a whisker of 5%.  The US 10-year rate ended the week above 4%.  Equities reversed their surprising post-CPI rally, the S&P500 falling over 2% on Friday, while the USD surged higher as risk appetite faded, taking the NZD back to 0.5560 by the end of the week.  In the UK, PM Truss sacked her chancellor and said she would go ahead with an increase to the corporate tax rate after all, saving an estimated £18b per year.  Over the weekend, new UK Chancellor Hunt has suggested that further fiscal U-turns are in store, so we should expect a stronger performance from the GBP today.

Starting off with the UK, where the new PM Truss’ proposed debt-funded fiscal stimulus is rapidly unravelling.  Under pressure from markets, the Bank of England (which ended its emergency intervention at the long end of the UK gilt market on Friday), and disgruntled MPs (watching the Conservative party’s popularity plummet in the polls), Truss sacked her chancellor and right-hand man Kwarteng on Friday.  Fresh from the previous week’s U-turn on the top tax rate, Truss announced that the government would go ahead with raising the corporate tax rate from 19% to 25% after all.  The U-turn on the corporate tax rate will save an estimated £18b per year (from the initial tax cut package of ~£45b) but leaves Truss’ policy platform and authority in tatters.  Bookmakers imply a greater than 50% chance of Truss being ousted before the end of the year.

Truss installed Jeremy Hunt, a fiscally conservative former minister in David Cameron and Theresa May’s cabinets, as the new chancellor in a bid to regain market credibility. In interviews over the weekend, Hunt has already suggested he is likely to take a knife to the Truss-Kwarteng tax package, putting on the table spending cuts and possibly other tax increases when he delivers the government’s fiscal statement, which will be costed by the independent budget watchdog, the OBR, at the end of the month.  The Sunday Times reported that Truss’ proposed 1p reduction to the basic rate of income tax would be delayed a year while Hunt will also be able re-examine the case for a windfall tax on energy firms.

Also over the weekend, BoE Governor Bailey gave his seal of approval to the corporate tax U-turn but said the fiscal measures announced to date (including the expensive energy price cap) “will require a stronger response than we perhaps thought in August”, possibly foreshadowing a big rate hike come the November meeting (the market is pricing a hike on the order of 100bps).  The BoE meeting takes place after Hunt’s medium-term fiscal statement, so the Bank will be able to factor in any changes to the fiscal package when it makes its rate decision and updates its economic forecasts.

The initial market reaction to the sacking of Kwarteng and the U-turn on the corporate tax rate suggested investors didn’t think Truss had gone far enough.  After falling sharply from 4.55% to as low as 4.25% on Friday, the UK 30-year gilt rate blasted up to almost 4.80%, with investors clearly wary about the potential for further de-risking from pension funds as the Bank of England’s emergency bond buying programme came to its scheduled end.  The GBP was down 1.4% on Friday, to around 1.1170, partially reversing its move over the preceding days as market speculation around a fiscal reversal gathered steam.  But given the talk around potential spending cuts and tax hikes from Hunt over the weekend and BoE Governor Bailey’s comments on the need for a sizeable monetary policy response, we should see a recovery in the GBP today and possibly some stability return to the long end of the gilt curve.

Global rates were higher again on Friday, with the US 10-year rate increasing 7bps, to end the week above the 4% mark, and the 2-year rate pushing up to 4.50%.  The implications of the upside surprise to US CPI continue to sink in, with the market now pricing a peak in the Fed funds rate of almost 5% by mid next year.  The market is fully pricing a 75bps hike from the Fed next month and a slightly better-than-even chance of a follow up 75bps hike in December.  Even some of the more dovish Fed officials are flagging the possibility of a higher terminal cash rate than the most recent ‘dot plot’, with San Francisco Fed President Daly saying, after a “very disappointing” CPI release, that “the most likely outcome ” was a peak cash rate between 4.5% and 5%.  Over the weekend, St Louis Fed President Bullard kept open possibility of back-to-back 75bps hikes at the next two meetings while saying it was “premature” to make a call on this just yet.

In economic data, US core retail sales (ex autos and gas) were stronger than expected, increasing 0.3% in September (with the prior month revised up too).  Retail spending remains firm, supported of late by lower gas prices and households dipping into their large saving balances.  The Atlanta Fed’s GDPNow measure suggests healthy annualised quarterly GDP growth of 2.8% in Q3.  The University of Michigan consumer confidence index nudged up to 59.8, with lower gas prices also likely a factor here, but it remains at very depressed levels on a historical basis.  The survey also showed an increase in 5 to 10-year inflation expectations from 2.7% to 2.9%, although this is well within the range seen over the past 18 months.  The rates market appeared to show a surprisingly large reaction to the University of Michigan data, which probably speaks to the jittery nature of the market at present.

The higher rates backdrop saw renewed USD strength and equity market weakness.  The S&P500 was down 2.4% and the NASDAQ just over 3% on Friday, both effectively reversing their surprising rallies after the US CPI data from the previous day.  The post-CPI rally in equities was put down to a technical correction amid extremely pessimistic sentiment and bearish market positioning.  But with market expectations for the peak in the Fed funds rate now bumping up against 5% and expectations growing that the global economy will slump into a recession next year, it wasn’t a major surprise to see the post-CPI rally in equities run out of steam.  Better-than-expected earnings results from several of the major US banks, including JP Morgan, Citi and Wells Fargo, didn’t alter the negative mood.

USD strength was the order of the day on Friday amidst a backdrop of renewed risk aversion and higher US rates.  The BBDXY index was 0.7% higher, more than reversing its 0.5% fall the previous day.  Alongside the GBP, the risk sensitive commodity currencies were the main underperformers on Friday, with the AUD falling 1.6% and the NZD off 1.4%.  Over the course of the week, the NZD was down almost 1%, ending near multi-year lows at around 0.5560.  The AUD was the weakest of the G10 currencies last week, falling 2.5%.  The NZD/AUD cross is approaching 0.90 for the first time since August.

The surge in US Treasury yields saw USD/JPY rally 1% to its highest level since 1990, at around 148.70.  Japanese officials have stepped up their warnings about yen depreciation, with Finance Minister Suzuki saying on Friday he was “deeply concerned” around the “unprecedentedly sharp and one-sided movements ”, which he blamed on speculative investors.  Over the weekend, Vice Finance Minister Kanda, responsible for currency, said Japan would take “bold action” to address the volatility, if required.  All this seems to suggest we should expect another bout of currency intervention from the MoF this week if the yen downtrend remains in force.  The US Treasury market is likely to remain twitchy about the prospect of ongoing large-scale FX intervention, although Japan still has large cash holdings at the Fed it can draw down first before needing to liquidate its cash bond holdings.

The 5-yearly National Congress of the Chinese Communist Party got underway yesterday, with Xi not giving any indication he is considering changing strategy from the country’s zero-Covid policy (consistent with the messaging from the Chinese press).

Domestic rates were higher again on Friday, with the 2-year swap rate increasing 5bps, to 4.94%, a fresh post-GFC high.  Like in the US, the market is now close to pricing a 5% terminal OCR and is attributing a not insignificant ~30% chance of a 75bps hike at the upcoming MPS in November.  Over the week as a whole, NZ swap rates were 21bps to 26bps higher, with global forces continuing to dominate market direction.  The NZ CPI release is the big release domestically this week.  We’re looking for a 1.5% quarterly increase in CPI in Q3, which would lower the annual rate to 6.5% y/y from 7.3% previously.  This would be marginally above the RBNZ’s 1.4% q/q MPS forecast.  There is likely to be as much, if not more, attention on the core inflation measures this time, given the RBNZ’s focus on core inflation in its last statement.

It’s likely to be another volatile week offshore this week.  The UK is likely to remain in the spotlight, including how the long end of the gilt curve will react to the absence of the Bank of England’s emergency bond buying this week.  In Australia, our NAB colleagues have pencilled in a 35k increase in employment in September and a 0.1% fall in the unemployment rate, which would take it down to a record-equalling 3.4%.  US earnings season starts to kick into gear with Bank of America, Netflix and Tesla among the companies reporting this week.